QE and the banks revisited

By Buttonwood

THE power of central banks over the economy is so great that the debate over the effectiveness of recent policy changes will rumble on for many years. This is all to the good, in a democratic society. But it is important to get the facts right. As my post earlier this week pointed out, the left seems to argue that quantitative easing (QE) was a handout to the banks. In particular, that QE was used to buy assets off the banks. (This post will focus on Britain, but the arguments apply elsewhere.)

There was reader scepticism about my contrary view, with one claiming that the banks had bought £100bn of gilts in the first quarter of 2009 to "front run" the Bank of England. But here is a link to the Debt Management Office website which has the details of gilt ownership (you have to open the spreadsheet entitled "distribution of gilt holdings"). At the end of 2008, the banks owned £25.7 billion of gilts; at the end of 2009, they owned £38.7 billion. They were buying, not selling. On the latest figures, they own £157.8 billion worth - largely because they need to hold safe assets like gilts to meet regulatory-imposed "liquidity ratios". These regulations are good for the taxpayer in two ways. First, they make it less likely that banks will collapse and need government rescue. Second, they turn the banks into eager buyers of bonds, keeping the lid on yields (and thus reducing the interest payments of the British government).

So from whom did the BofE buy the gilts? The aim was to buy them from pension funds and insurance companies, but the holdings of those two institutional categories have also risen by £232 billion since end-2008. However, the total amount of government debt has risen by £1 trillion over the same period. Pension funds and insurance companies are natural buyers of gilts for regulatory reasons (and because pension funds have to pay retirees who need income). But the proportion of gilts held by these institutions has fallen from 38.4% at the end of 2008 to 28.9% now. In other words, without QE, the institutions might have had to buy more gilts. The category of "other financial institutions" (largely mutual funds) has increased its absolute holding but in proportionate terms, it has fallen from 22.4% to 9.9%, probably because investors have switched into corporate bond funds in search of higher yields. That is exactly the kind of portfolio effect (encouraging investors to buy risky assets) the Bank of England was trying to engineer.

So if the Bank of England wasn't buying gilts from the commerical banks, what arguments does that leave the bank bailout camp? Undoubtedly, there will have been some bank profits from market-making. But those would occur if a Labour government implemented its plan for "people's QE" with a National Infrastructure Bank selling bonds to investors; somebody would have to make a market in those. One can guarantee that supporters of people's QE won't use that argument to say the programme is a bank bailout. In any case, any market-making profits will be offset by the loss of income stemming from a flatter yield curve (banks borrow short and lend long so they want as wide a gap between short and long rates as possible). Paul Krugman, no great friend of the finance sector, made this point in 2012.

The final argument is that QE made it easier for borrowers to service their debts and that was a boost to the banks. Yes, the point was to help reduce the burden on indebted companies and homeowners. Any package that boosts the economy reduces bad debts, including tax cuts. A "helicopter drop" of newly created money, as proposed by Mark Blyth and Eric Lonergan, would do the same. On this logic, governments should do nothing to stimulate the economy in case the banks gain an indirect benefit. That is bizarre reasoning.

Yes, the government and Bank of England did rescue the banks, but through direct capital injections and liquidity provision. Those were different programmes to QE. Describing the latter as a £375 billion handout to the banks is completely misleading.